Capital expenditures are an important thing to understand, and be prepared for, in any real estate investment. Understanding what capital expenditures are, how they're taxed, and how to budget for them can have a significant impact on your real estate profits.
What are capital expenditures?
Capital expenditures are the money used to add to or improve a property beyond common repairs and maintenance. Capital expenditures are used for investment properties, equipment, and other fixed business assets. Many people refer to capital expenditures as capex.
Since the cost related to these improvements is usually substantial, many real estate investors with long-term goals set aside cash from their monthly revenue to put into reserves. Having reserves in place protects investors from the large capital outlay when a major repair or improvement is needed. Having cash available to cover these capital expenditures is important to be able to keep receiving cash flow from the property.
Money set aside for these reserves is not listed as an expense on the income statement like operating expenses are. Although the reserves affect your free cash flow, capital expenditures are only reported on taxes when you actually have the expense of the improvement or repair.
While an income statement may show the entire cost of the capital expenditure to show a true picture of annual cash flow, it is a depreciation expense on your financial statements and tax return. The depreciation schedule will depend on what's included in the specific improvement or equipment. The expense may even qualify for bonus depreciation or a Section 179 deduction.
What is included in capital expenditures for real estate?
Common capital expenditures for a real estate asset, like rental properties and commercial real estate, include improvements to the property such as renovations and major repairs. Some major repairs made to upgrade and maintain the property include replacing the roof, windows, or siding. A capital expenditure is intended to improve the component to like new condition or extend the life of the asset. Purchasing certain equipment to be used in the operation of a real estate investing company would also be considered a capital expenditure.
In fact, a capital expenditure is considered an investment into the business instead of an expense that affects cash flow. A company's balance sheet will show any funds used by a company for capital expenditures listed as an investment. The expense listed on the financial statements will be the depreciation from that capital investment.
Examples of capital expenditures for real estate include:
- New roof.
- New HVAC.
- Major appliances.
- New flooring.
- Complete overhaul of plumbing or electrical.
- Bathroom and kitchen remodels.
- Paving (not repairing) a parking lot or driveway.
Capital expenditures vs. maintenance and repairs
In some instances, trying to determine whether a certain repair or improvement is considered a capital expenditure or a repair or maintenance can be confusing. In most cases, you can ask yourself whether the project is returning the asset to its previous condition or returning the property to like-new condition.
For example, replacing an entire roof would be a capital expenditure because it is a new roof and is extending the asset's life. Repairing a section of a roof is simply a repair and is included with ordinary operating expenses because it's only allowing the asset to continue its current useful life.
An improvement to the asset that isn't necessary to continue its useful life but is instead made to increase the value is considered a growth capital expenditure. Repairs needed for the asset to continue being useful are considered maintenance capital expenditures.
Examples of capital expenditures vs. repairs and maintenance